Vapor trails

A hot deal for an electronic-cigarette seller shows where there’s no smoke, there’s fire.

By Ken Otterbourg

Last April 25, blu ecigs had big news to share with its 30,000 Facebook fans: It had agreed to be bought by Lorillard Corp. for an eye-popping $135 million. The reaction was swift, and it wasn’t all congratulatory. Complaints were posted. One commenter wrote, “I feel dirty … it’s like buying a bible from a satanist or child safety equipment from a registered pedophile.” Though the companies are within 100 miles of each other — blu is based in Charlotte; Lorillard’s headquarters and factory are in Greensboro — in many ways they are a world apart. Started in 2008, blu sells electronic cigarettes. Lorillard, founded in 1760, is a bastion of Big Tobacco, its Newport brand the nation’s top menthol cigarette. Another commenter on the Facebook page put it this way: “It was good for y’all to get that money from the one industry everyone who ever bought a blu was trying to escape.”

Members of blu’s social-media team worked the site hard, responding to criticism and pledging that nothing would change. It was still business as usual, they said, but, of course, that wasn’t exactly the case. Since then, the snarkiness of blu’s home page has become more muted. There are fewer posts mocking smokers and their dirty, ash-strewing habit. And all the posts lambasting the company? They’ve been removed.

Change is sweeping through the e-cigarette business as it moves from sidestream to mainstream. Sales are soaring, estimated at close to $300 million in 2012. But the boom is bringing growing pains. For an industry that was fiercely and proudly independent of Big Tobacco, Lorillard’s entry is a sign that the grown-ups have joined the game and are likely to reshape the playing field to their needs. This all comes as the U.S. Food and Drug Administration is starting to develop regulations on e-cigarettes that will help determine how the products are sold and marketed and how they compete with the real deal. There’s hype, and there’s hope, and everything in between. “As far as the industry is concerned, it’s a pretty big mess right now,” says Ray Story, the president of the Tobacco Vapor Electronic Cigarette Association, a trade group based in Alpharetta, Ga. “It’s the wild, wild West. This is a fantastic industry that can change humanity. My biggest issue is to make sure we have some kind of regulations we can work with and parameters of how we operate.”

The tobacco industry has been chasing a smokeless cigarette for decades (Remember James Garner as RJR Nabisco Corp. CEO Ross Johnson puffing one in the HBO movie version of Barbarians at the Gate?) but had little to show for its efforts until eight years ago. That’s when Hong Kong-based Ruyan Group (Holdings) Ltd. released the first versions of the electronic cigarette. The components themselves are not groundbreaking, but advancements in miniaturization — think of the electronic jingle in a greeting card — allowed all the parts to be crammed inside a small tube that could be cradled between your middle and index fingers. Inside the tube are a cartridge, an atomizer, a battery and a small light. When you suck on the mouthpiece, you activate the battery, which powers the atomizer and turns on the light. The atomizer heats and vaporizes the liquid in the cartridge, which includes nicotine, flavorings and some form of glycerin.

It’s not smoking — there’s no smoke. The term users have coined is “vaping.” E-cigarettes offer a reasonable approximation for a habit that physiologically is built on the absorption of nicotine but really encompasses a much wider range of senses. These products feel good in your hand. The light simulates the lit tip of a cigarette. The nicotine bites a bit in the back of the throat, and the glycerin upon exhale condenses into a vapor that hangs around just long enough to be seen. With practice, you can even blow a vape ring.

The first e-cigarettes that made it to the U.S. were a work in progress. The batteries could be iffy. The cartridges sometimes leaked. The flavorings could be harsh and inconsistent. But there was a core of smokers who were ready to give them a try, and pretty soon a sprawling online community developed that was dedicated to sharing their opinions of the different products and proclaiming their love of all things vaping. It’s into this scrum that Jason Healy, blu’s president, dove in 2008. His journey to being the future of Big Tobacco is both likely and unlikely. He grew up in Australia, where his dad was a morning radio personality in Brisbane. He first came to the United States to play basketball in high school, then returned home after a few years in college and went into promotions. From there, he helped run Funbox, an Australian company that developed and peddled adult content for cellphones. When he sold his stake in 2007, he looked to America and Charlotte (his wife is from Statesville) for a new venture.

What Healy, 38, says he saw in electronic cigarettes was opportunity. The industry was growing, but there were no truly established players. It was all being sorted out. His goal was to bring branding to the product and to raise its quality so it could move away from being a novelty. Healy and 11 other investors launched blu in May 2009, relying heavily on social media, giveaways and sponsorships of events to build an online brand before moving into the bricks-and-mortar end of the retail business. Its latest innovation is a signaling device in the pack that goes off when another blu user is close by. Blu now has 50 or so employees, most at its headquarters, where online orders are filled. Wholesale orders go through a warehouse in Atlanta. It also has third-party operations in China, where the devices are made. Sales leaped from $25 million in 2011 to $76 million in 2012.

Healy dismisses complaints about selling the company to Lorillard as carping from a small group of critics who fail to see the big picture. “When you look at it, the reason it’s going to survive through regulation and have the resources is because of Big Tobacco. That’s just the nature of it.” As part of efforts to build its presence, blu recently has taken to the airwaves. Cigarette advertising has been banned on television and radio since 1971, but the Public Health Cigarette Smoking Act defines a cigarette as a product that contains tobacco. With that loophole in hand, blu’s campaign features Stephen Dorff, a midlevel actor, urging smokers to “rise from the ashes.” It’s not catchy like the Winston ads of the 1950s or epic like the theme from The Magnificent Seven that accompanied Marlboro’s, but it is jarring to see something approximating a cigarette being sold on late-night TV. Healy’s goal is simple: “To eventually sit a blu down in front of a smoker, sit it next to their pack of cigarettes, and they’re going to pick up the blu. There’s no reason for them to pick up tobacco.”

He expected blu to get a purchase offer eventually, but he thought it wouldn’t come so soon. Two tobacco companies came calling early last year, and his management team gravitated toward Lorillard. (He declined to name the other one.) “They wanted to get in early and get a head start. They very much embraced us, and it’s a tough thing for tobacco to embrace a product that could conceivably and by design replace them. To take that route, as opposed to a Philip Morris, who has, I think, sat back, that takes a lot of foresight to say, ‘OK, in 20 years where are we going to be and how do we [bring a] return to shareholders?’ This is the market. This is the brand.”

Lorillard is the oldest, smallest and most traditional of the three big tobacco companies. While Winston-Salem-based Reynolds American Inc. and Richmond, Va.-based Altria Group Inc. (parent of Philip Morris) have sought to offer a range of tobacco products, from chewing tobacco and snus and beyond, Lorillard has for years made only cigarettes. Even in that category it was a specialist, with most of its eggs in its Newport basket, a powerhouse brand that skews heavily toward black smokers. Lorillard has a 14% share of the retail cigarette market, giving it freedom to make a big push into e-cigs. If smokers switch, most weren’t Lorillard customers to start with.

In August 2010, Lorillard hired Murray Kessler as its new CEO. He came from Altria’s UST division, which makes the Skoal and Copenhagen brands of smokeless tobacco. Bob Bannon, Lorillard’s director of investor and media relations, says Kessler has pushed the company to grow beyond Newport and menthol while still remaining committed to cigarettes. Hence, Newport nonmenthols and aggressive promotion of its discount brand, Maverick. “This is an adjacent cigarette opportunity,” Bannon says of blu. “The typical e-cig user is a dual user. Lorillard’s belief is that there’s not a lot of overlap with Newport users. We largely view e-cigs as an extremely attractive category that is complementary to the cig industry.” It also wants to avoid what might be called a Kodak moment. Says Bannon: “We don’t want to be looking back in 20 years like Kodak did with digital photography when it said we just need to stick to our knitting and the film business.”

Discussing blu with analysts, Kessler had a hard time concealing his enthusiasm. He said blu’s sales for the fourth quarter of 2012 were up sharply, to $39 million (compared with $1.7 billion for the entire company). But Lorillard is just starting to truly roll the product out, using its distribution network to move blu from its pre-acquisition base of 10,000 stores to more than 50,000 at year’s end. “You only get one chance to be first and best,” Kessler said. A disposable blu costs about $10 and supplies puffs equivalent to about a pack-and-a-half of tobacco cigarettes. Rechargeable kits start at $70.

Kessler likened the acquisition to a long-term research project with an enormous upside. “I think the product’s 20% of the way to where it could be. But we have the vehicle right. The category already sells more than snus and all these other efforts at getting into a cigarette alternative. So I mean that the key thing is that the technology works and consumers love it. And, over time, we need to get the satisfaction, performance, flavors, get the taste even stronger, get quality-control even stronger.”

Reynolds has an electronic cigarette called Vuse in extremely limited distribution. It won’t discuss the product, but CEO Daniel Delen told analysts that the company plans to compete aggressively in this market. “We wanted to assure you that not only do we intend to compete in this area, but we also believe the product development we have under way will truly deliver against adult tobacco consumer expectations.” The problem, he believes, is that the products available aren’t quite good enough. “When we look at the vapor category today, I think there’s a fair amount of consumer interest in products like that. But what we see is very high levels of trial and relatively low levels of conversion.” Complicating the picture is that the Master Settlement Agreement cigarette companies signed in 1998 precludes them from creating e-cigs with the same brands as their current cigarettes. So there won’t be electronic Newports or Pall Malls.

U.S. cigarette companies sold more than $30 billion of smokes at wholesale in 2012. That makes the e-cigarette business somewhat of a rounding error for now. It’s expected to reach $1 billion soon. Bonnie Herzog, an influential New York-based analyst with Wells Fargo Securities, says that with improved products, better distribution and greater awareness, sales could surpass those of tobacco cigarettes in 10 years or so. She expects consolidation and a board tilting toward the cigarette companies. In a research note last year, she wrote: “We can’t help but continue to draw a parallel between e-cigs and the energy drink category; we think e-cigs are to tobacco what energy drinks are to the beverage industry. Therefore, we think big tobacco needs to wake up and recognize the potential opportunity of the e-cigarette category and not make the mistakes of the large beverage companies that overlooked the potential of the energy drink category when it was in its nascent stage. Bottom line — we believe e-cigs are more than just a fad and most of our industry trade contacts agree. Considering both LO and RAI have dipped their toes in the e-cig waters, the next move is MO’s [Altria] and we expect it to be big.” In a conference call with analysts, Altria simply said it’s monitoring the situation closely.

In business-school lingo, what’s happening is called disruptive innovation, a term used to describe a product introduction that comes from outside the industry’s dominant players and is frequently discounted because the large companies are focused on protecting profits from existing ventures. By the time they wake up, it can be too late. Think of Red Bull versus Coke and Pepsi. Or the explosion of Greek yogurt. But for the tobacco business, the best example is closer to home. It’s the filter tip, which reordered the industry, transforming Philip Morris and its Marlboro brand from an also-ran into the juggernauts they are today.

This year marks the 100th anniversary of Camel, the first blockbuster cigarette brand in America, as dominant in its day as Marlboro is now. It appeared the same year a hyphen joined the towns of Winston, where R.J. Reynolds Tobacco Co. had its headquarters and factories, and Salem (names of both would become filter-cigarette brands in the ’50s). Since then, there has been a century of research and observation about how and why people smoke, the harm it causes them and the difficulty many have quitting. It’s taken years of legal battles and political wrangling to develop today’s level of regulation and control. With electronic cigarettes, there is little in the way of research to guide public policy. Is using nicotine in and of itself harmful? Do electronic cigarettes help people quit smoking? Or do they just make it easier for them to avoid quitting by offering a bridge for all the times when they can’t smoke? For better or worse, the marketplace has gotten ahead of the research and regulation.

The FDA’s first attempt at regulating e-cigarettes began in 2009, when the agency moved to classify the products as being drug-delivery devices and therefore falling under the rules of the Food, Drug and Cosmetic Act. And because most of the products are made or assembled in China, the agency also tried to block their import. The industry’s response could be called the Cheese Whiz defense. In other words, an e-cigarette — like a can of cheese — might look different from its traditional counterpart, but it’s still delivering the same product. The e-cig companies won in federal court and then at the U.S. Court of Appeals. E-cigarettes, the court ruled, were just another tobacco product and, as long as they weren’t marketed for therapeutic purposes, had to be regulated through the Tobacco Control Act. The FDA said it wouldn’t appeal but would develop regulations for e-cigarettes as tobacco products. That was nearly two years ago, and the industry is still waiting.

The key question that remains to be answered is what are e-cigarettes’ net effect on public health, says Danny McGoldrick, head of research at the Campaign for Tobacco Free Kids, based in Washington, D.C. “If they’re simply used to keep people from quitting, that’s no good.” He views Big Tobacco’s push into e-cigarettes as a mixed bag, remaining skeptical of whether the industry wants to stop people from smoking but aware that its deep pockets will change the regulatory balance. Lorillard, for example, can’t claim that the costs of compliance are too burdensome, he says.

The company has plenty of experience with tobacco regulations. It has been battling (or working with, depending on your point of view) the FDA and its scientists since 2009 over whether menthol tobacco cigarettes should be banned or subject to more stringent restrictions than nonmenthols. Healy says Lorillard’s expertise will be critical for helping e-cigarettes get to the next level. “If Big Tobacco didn’t get into it and the FDA dropped their regulations tomorrow, we’d all be gone. Nobody has the resources to meet those expectations.” That said, he also acknowledges the downside of being part of Big Tobacco: The public doesn’t exactly trust the industry to do the right thing. He jokes that he had his own concerns when he started negotiations with Lorillard. “I expected tobacco people to have horns and to fly off to their planet at night.” But he praises Lorillard as a proactive corporation with integrity and strong values.

The company that took on the FDA over its regulatory grab is Scottsdale, Ariz.-based Scottera Inc., which does business as NJOY. Its brand is the industry’s best-seller, with about 40% market share (blu has about 30%) and has been signing distribution deals with convenience-store chains at a rapid rate. Roy Anise, a former Altria executive who is executive vice president of the closely held company, says the market is quickly consolidating as it moves from online to retail, where distribution channels require more investment than just maintaining a website. NJOY’s newest product has a soft tip and paper-like covering, closely replicating a conventional cigarette. And like blu’s offerings, it has a flip-top pack that users can plunk down at a bar and proclaim their brand. “Our strategy is to obsolete cigarettes,” he says. While most observers expect Reynolds and Altria to become major players, he isn’t so sure. First, they would be taking sales from themselves. Second, e-cigarettes aren’t like their other products. The marketplace requires nimbleness, he adds. “It’s not really tobacco. It’s more like consumer electronics.”

Since the surgeon general’s first report on smoking and health in 1964, the war on tobacco has been waged on three fronts. First, tell people that smoking is harmful. Second, tax cigarettes to the hilt to make them expensive. Third, ban smoking in public places, making it more difficult to light up. And underpinning all of these approaches was the central tenet of the public-health community: There is no acceptable level of smoking or use of nicotine, a belief referred to simply as “Quit or Die.” Mitch Zeller used to be in that camp. He has spent most of his career in tobacco control, including a stint as the director of the FDA’s Office of Tobacco Programs. The public-health profession, he says, is torn by e-cigarettes. Some health advocates see them as having enormous potential for reducing harm. Others see a stalking horse for cigarette companies, a way for smokers to keep smoking and maintain their nicotine habits. “My thinking has evolved. We have to be honest with ourselves. There’s a continuum of risk. The anchor points might be cigarettes on one end and nicotine pharmaceuticals on the other. What we want is a future when cigarettes are out there but nobody uses them.”

One of the selling points of e-cigarettes is that they can be used in many places where smoking isn’t allowed. Many airports allow them — though most airlines don’t. North Carolina’s public-smoking ban says nothing about vaping, so there is growing use of e-cigarettes at restaurants and other public places here. The balancing act for e-cigs is to exist in two worlds: to be considered a nontobacco product in places where tobacco use is banned while still falling under the Tobacco Control Act (as opposed to being regulated as a drug-delivery system). It’s also to figure out a taxation plan that reflects their reduced harm as well as the need of state and federal governments to replace lost excise taxes as cigarette sales fall. Then there is the workplace, where smokers huddle outside office buildings on their breaks. Healy and his team are engaged in educating businesses and creating pilot programs with companies to allow the use of e-cigs in the office. “People don’t understand the productivity side from a business’s point of view. And instead of going, ‘We don’t hire smokers,’ which I think is wrong, hey, let’s look at some alternatives and how we can better do this.”

Healy still joins those huddles. In contrast to Lorillard’s opulent headquarters in the swankiest office park in Greensboro, blu’s offices are in a nondescript building in south Charlotte, a three-story job that it shares with some information-technology companies, an insurance adjuster and the like. Since starting blu, he gets to the end of the day and realizes he hasn’t been outside for hours, instead vaping away while he works. But old habits die hard. He no longer smokes a pack and a half a day, but each morning he joins other smokers outside when he gets to work. He has a cup of coffee and a real cigarette, then another one at the end of the day. “Those are still the two ones,” he says, “I’m not interested in replacing.”